Crash Explainer 1: Leverage

This post, and others that will (hopefully) follow, grew out of my conversations with my boss, Mark Schwartz. Mark and I have been talking through the crash to establish for ourselves what went wrong. Hopefully, our discussions will be useful to others.

In April, I heard Larry Summers on the radio. He opined that all financial crisises have two things in common, "greed and leverage." Since greed is pretty straightforward, I'm going to start by talking about leverage. Put simply, leverage is a measure of how much borrowed money a business is using. It is generally expressed as a ratio: a highly leveraged business has a lot of debt in comparison to equity.

There are regulatory constraints on how leveraged banks and investment banks can be. Government regulators use leverage and other ratios to measure the financial stability of regulated entities. These "capital adequacy" requirements are designed to ensure (in the case of the Fed) that a bank can continue to do business, or (in the case of the SEC) that a broker-dealer can repay all its debts.

Any entity loaning money will also look at the borrower's leverage ratio as a measure of the likelihood that the loan will be repaid.

Imagine a hypothetical company wishing to borrow money - it's lender asks for financial statements and a number of financial ratios. To do the math necessary to arrive at these ratios, every asset must be given a value, and that's where things get complicated ... NEXT: Valuation